Mergers and acquisitions (“M&A”) involving private companies require a detailed, cautious approach. While many deals move forward smoothly, hidden pitfalls in the agreement can lead to costly legal and financial consequences. Here are five red flags commonly found in M&A agreements and how having experienced legal counsel can help protect your interests.
1. Vague or Missing Representations and Warranties
Representations and warranties are the backbone of risk allocation in any M&A agreement. If these are vague, incomplete, or missing, it’s a serious concern. For example, a vendor should be required to represent that the business is in compliance with Ontario laws and that its financial statements fairly present its condition. Without precise language, a buyer may unknowingly inherit undisclosed tax liabilities, litigation risks, or regulatory non-compliance, particularly problematic in regulated industries.
Some key vendor representations and warranties buyers often seek include confirmation of valid corporate existence, authority to complete the transaction, clear title to shares (if the transaction is a share sale), and accurate financial records. These should also touch on legal compliance, ownership of intellectual property, and any pending or threatened litigation.
However, overly detailed warranties can overwhelm or delay a transaction, especially if they aren’t properly tailored. An experienced lawyer helps strike the right balance, ensuring your protections are robust without discouraging deal flow.
2. Weak or Absent Indemnity Provisions
Indemnification provisions determine how parties are compensated for breaches of the agreement, particularly representations and warranties. If the indemnity clause is too limited, or missing, buyers could be exposed to significant financial harm without recourse.
For instance, vendors often seek to cap their liability or limit it to a specified period (the “survival period”). Buyers should ensure that there are carve-outs for fraud or fundamental representations that survive beyond those limits. Legal counsel can help negotiate reasonable baskets, caps, and timelines that balance risk while remaining market-appropriate.
3. Undefined or Ambiguous Earn-Out Terms
Earn-outs – payments contingent on the future performance of the business – are common in private M&A. However, vague earn-out provisions are a major red flag. Disputes often arise over how performance is measured, what counts as revenue, and whether the buyer has a duty to operate the business in a way that supports the earn-out.
Enforceability hinges on certainty of terms. A well-drafted earn-out clause should include clear performance metrics (e.g., EBITDA), specific time frames, and dispute resolution procedures. Legal advisors help ensure these terms are enforceable and protect both parties from post-closing tension.
4. No Conditions Precedent
Conditions precedent are essential safeguards that ensure a deal only closes if specific requirements are met. These can include satisfactory due diligence, obtaining third-party consents (e.g., landlord or franchisor approvals), securing financing, or receiving regulatory clearances.
If an agreement lacks meaningful conditions precedent, the buyer may be forced to close on a business with hidden risks or incomplete information. Ontario law permits parties to walk away from deals that don’t meet agreed conditions, but those conditions must be clearly spelled out. A lawyer can help structure these conditions to ensure your ability to exit the transaction if critical issues arise.
5. One-Sided Covenants
Covenants are obligations to take or refrain from certain actions before or after the closing. A common red flag is when these covenants are heavily weighted in favour of one party. For example, if the vendor is subject to a lengthy non-compete while the buyer assumes no obligation to maintain core operations, or if the territory of the non-compete is unjustifiably large for the nature of the business, the agreement may lack fairness and expose the vendor to unreasonable restrictions.
Ontario courts scrutinize the reasonableness of restrictive covenants – especially non-compete clauses. A legal advisor will help ensure these clauses are enforceable, time-limited, and tailored geographically and operationally. Fair, mutual covenants help build goodwill and reduce the chance of litigation.
Conclusion
A well-structured M&A agreement is more than a formality; it’s a risk management tool that protects your interests and investment. Spotting red flags like vague warranties, weak indemnities, or one-sided covenants is critical to a successful deal in Ontario’s legal and business environment.
Working with a member of Hummingbird Lawyers’ M&A team ensures that your agreement reflects best practices, complies with local laws, and is built to withstand challenges both at closing and beyond.
